In these notes:
I.     Money and finance
II.    Financial instruments: an introduction
III.  Financial institutions: An introduction
IV.  Financial intermediation

I. MONEY AND FINANCE

Money is a means of financing purchases. What does FINANCE (the verb) mean?

FINANCE = to pay for

The simplest of the methods of finance is BARTER (trading one commodity for another) -- e.g., I give you give my Mark McGwire rookie card, you give me your car -- but those kind of transactions are relatively rare in modern society. More often, one finances a purchase with MONEY or CREDIT (borrowing, usually from a third party). In addition, "finance" often refers to the raising of money in order to make some big purchase -- for example, a corporation that wants to spend $100 million on new plant and equipment but doesn't have the cash might issue new stock (shares of ownership in the corporation). Issuing new stock is called equity financing. While you hear an awful lot about the stock market and IPOs (Initial Purchase Offerings), issuing new stock doesn't really account for that much of the external funds of American businesses. (The figure is about 2%). More than 90% of those funds are raised by borrowing, either through loans (62%) or through bond financing (30%). A bond is a formal I.O.U. Bond financing involves raising money by selling bonds to people and institutions, and paying a fixed amount of interest to those people at regular intervals, and repaying the original amount (the "principal") at the end of some fixed term (say, 1 year or 10 years or 30 years).

Three main functions of money:

1. Medium of exchange; generally accepted form of payment -- You can use it to buy things.

2. Unit of account -- You can use it to price things.  Ex.:  new textbook is $105, Wall St. Journal (WSJ) subscription is $35, phone call on Sprint is 10 cents a minute. Quoting prices in terms of money (dollars and cents) is a lot easier than quoting prices in terms of other goods -- e.g., Mishkin's textbook = 3 WSJ subscriptions or 1,050 minutes of long-distance calling.

3. Store of value -- an asset in its own right, and not a bad one -- while cash earns no interest, it's perfectly liquid (convertible into cash) and has no default risk

II. FINANCIAL INSTRUMENTS: AN INTRODUCTION

Once again: to "finance" something means to pay for it.
--> Since money (or credit) is the means of payment, "financial"basically means "pertaining to money or credit."

In macro and micro courses, the usual focus is the real sector of the economy, in which goods & services are produced and sold to households, firms, and the government. But the efficient functioning of the real sector requires a financial sector: Barter (swapping goods for goods) is inefficient -- having some kind of money that can be used to pay for goods is a lot more efficient. Likewise, if borrowers (firms and consumers alike) had to borrow directly from savers, they might have a hard time finding each other. With a financial sector to channel money from savers to prospective borrowers, the volume of investment and durable-goods consumption is a lot larger than it otherwise would be.
-- For every real transaction, there is a financial transaction that mirrors it.
---- It could be as simple as cash changing hands. Ex.: I buy a bagel and coffee at Port City Cafe for $3.00. In GDP accounting, that would be entered as consumption of food services. It's also a financial transaction -- a transfer/exchange of $3.00.
---- It could be as complex as a leveraged buyout, done with the assistance of an investment bank and the selling of junk bonds.

Just as in a bank balance sheet, every financial asset has a corresponding financial liability.
-- Financial asset: any financial claim or piece of property that can be owned. Financial assets usually have no intrinsic value of its own. Instead, their benefit to the owner depends on the issuer of the asset meeting certain obligations or fulfilling certain expectations. Exs.: bonds, stocks.
-- Financial liability: the obligation that the issuer of an asset has to the owner/buyer of that asset.
---- Ex.: a 10-year, $1000 government bond. Government must pay back $1000 + interest.
---- Ex.: a dollar bill. It's the Federal Reserve's liability, since the Fed must make sure that the value of that dollar doesn't depreciate too much and must maintain a stable currency.
-- A financial instrument, or a security, is a more general term for a financial asset/liability.

Financial instruments are bought and sold in both PRIMARY and SECONDARY MARKETS.
-- PRIMARY FINANCIAL MARKET: where newly issued financial assets are bought and sold (likely to finance investment in new physical capital, i.e. plant and equipment)
-- SECONDARY FINANCIAL MARKET: where previously issued financial assets are bought and sold. The stock market is by and large a secondary financial market, with new issues accounting for less than 1% of total shares outstanding. (Although not directly connected with new investment, having a secondary financial market probably raises the level of investment, and hence raises the stock of physical capital, because it makes stocks and bonds a lot more liquid, since you can resell them any time you want.)

SOME IMPORTANT FINANCIAL INSTRUMENTS (listed in descending order of their total value as of 1999; see also Mishkin's Chapter 2, Tables 1 and 2 [pages 26 and 29].  The tables show how the volume of these various instruments has changed in recent decades.)
 

MONEY MARKET INSTRUMENTS (short-terms debts; maturity of < 1 year)

CAPITAL MARKET INSTRUMENTS (equities, & long-term debts with maturity of > 1 year) (also includes bonds that mature in exactly 1 year)

* COMMERCIAL PAPER-- similar to bonds; formal, short-term IOUs promising that a certain sum of money plus interest will be paid back on demand.Usually issued by large corporations, as an alternative to borrowing money from a bank (at a higher interest rate).  The total market value of commercial paper in the U.S. was $1.26 trillion at the end of 1999.  * negotiable bank CD's (resellable, redeemable early; these tend to be very large CD's)  * U.S. Treasury bills (T-bills)-- short-term IOU's to finance the government's deficits * REPURCHASE AGREEMENTS (REPOS) -- short-term loans, usually from corporations to banks, with T-bills serving as collateral. An important source of bank funds since 1969.  * EURODOLLARS-- U.S. dollars deposited abroad. American banks often borrow Eurodollars, either from their own foreign branches or from other banks, when they need cash.  * FEDERAL FUNDS -- overnight loans between banks of their Federal Reserve deposits. These loans are usually made so that the borrowing bank can meet its reserve requirements at the Fed. The federal funds rate is a key target of Fed policymakers.  * BANKER'S ACCEPTANCES-- formal IOUs issued by a firm and guaranteed by a bank, in case of default by the firm. These are used mostly in the course of international trade and have been around for centuries.

* STOCKS-- shares of ownership in a company; typically includes right to a periodicshare of profits (dividends), plus rights to a share of the company's physical assets if the company fails. The stock market is by far the largest capital market: U.S. stocks had a combined value of nearly $20 trillion at the end of 1999.  * MORTGAGES-- loans to households, tofinance purchases of homes or land. The largest debt market in the U.S. (total value of about $5 trillion at the end of 1999.) Can be held indirectly as an asset, thru Real Estate Investment Trusts (REITs).  * CORPORATE BONDS-- long-term bonds issued by corporations. They typically pay interest twice a year, and pay off the principal at a specified maturity date. Convertible bonds are corporate bonds that may be converted into stock at any time.  * U.S. TREASURY BONDS-- to finance government deficits. The most widely traded bonds in the U.S., their trading volume normally exceeds $100 billion daily.  * U.S. Government AGENCY BONDS -- issued by the likes of Ginnie Mae (GNMA, the Govt. National Mortgage Assn.) and the Tennessee Valley Authority.  * STATE & LOCAL GOVERNMENT BONDS (municipal bonds) -- issued by state & local governments to pay for long-term projects not covered by current tax dollars. Sold mainly to commercial banks, mutual funds, and wealthy individuals. Completely tax-exempt.  * CONSUMER & BANK COMMERCIAL LOANS. Usually have no secondary (resale) markets.

Those commercial loans are "last but not least" -- more than 3/5 of the external funds of American businesses come from loans, as opposed to equity or bond financing. Also, they account for the vast majority of household debt.  

III. FINANCIAL INSTITUTIONS: AN INTRODUCTION

FINANCIAL INSTITUTION -- a business whose primary activity is buying, selling, or holding financial assets.
-- Key subset: FINANCIAL INTERMEDIARY -- a business that connects savers with borrowers.

Types of financial institutions:

1. Depository institutions (BANKS, CREDIT UNIONS, SAVINGS & LOAN ASSOCIATIONS)
-- their main liabilities (sources of funds) are deposits, and their main assets are loans

2. Financial brokers
-- INVESTMENT BANKS: sell new securities for companies. They don't hold deposits, or make loans. (They hold zero assets/liabilities.)
-- BROKERAGE HOUSES: buy/sell old securities on behalf of individuals

3. Investment institutions
-- MUTUAL FUNDS: get money from small savers (individuals), who buy shares in the fund; they in turn invest in variety of stocks, bonds, etc.; allow the individuals to "pool" their savings, diversify (avoid risk)
-- FINANCE COMPANIES: like banks, they use people's savings to make loans to businesses, but instead of holding deposits, they sell bonds and commercial paper

4. Contractual intermediaries -- they hold and store individuals' savings over long term
-- PENSION FUNDS
-- INSURANCE COMPANIES

IV.  FINANCIAL INTERMEDIATION

The process of borrowing and lending through intermediaries like banks, mutual funds, etc. is called FINANCIAL INTERMEDIATION or INDIRECT FINANCE.
-- All of the above types of financial institutions, except for financial brokers, are financial intermediaries.
-- As a source of funds for American businesses, indirect finance is far more common than direct finance. For every dollar that firms raise by borrowing directly from households or selling stocks directly to households, they raise about $20 through indirect finance -- bank loans, selling bonds and stocks to mutual funds, pension funds, insurance companies, etc.
-- [See Mishkin's Chapter 2, Figure 1 (page 24), "Flow of Funds Through the Financial System."]

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Q: Why don't people just borrow and lend money to each other directly?Why is financial intermediation so common?
A: Two main reasons:
(1) Transactions costs (time and money spent carrying out financial transactions) are often prohibitively high for individual borrowers and lenders. Financial intermediaries, by handling a large volume of such transactions, develop an expertise that allows them to make additional transactions much more cheaply than you or I could. Financial intermediaries, by contrast, reap economies of scale -- by doing a lot of business, they reach a point where the cost per dollar of transactions becomes smaller and smaller.
(2) Asymmetric information: The borrower has much better information about his ability and intention to repay than the lender does -> This makes lending money very RISKY. Is the borrower a good credit risk? Once the loan is made, is the borrower going to engage in very risky activities that will make it unlikely that you get repaid? If you're thinking about loaning someone money but aren't sure about the answers to those questions, then you're probably not going to loan the person any money. A bank, on the other hand, employs a number of specialists who are expert in sniffing out whether or not a potential borrower is credit-worthy.